Frontline Thoughts - The Bernanke Era
Oct 31, 2005
The King is going. Long live the King. We now know that Ben Bernanke will be the next Fed Chairman. His approval by the Senate is as close to a lock as you can get. This week we focus on Bernanke, and specifically his most famous, and what I think one of the most important speeches ever by a Fed governor. We will look at how policies might change, the risks involved. Bernanke faces some very real challenges. We should all wish him well.
First, let's look at who Bernanke is: Dr. Ben Bernanke was the Chairman of the Department of Economics at Princeton. He was the Director of the Monetary Economics Program of the NBER (National Bureau of Economic Research) and the editor of the American Economic Review. He co-authored a widely used textbook on macroeconomics. He is obviously well-respected in economic circles. He was appointed to the Board of Governors for the Fed in 2002. He was appointed the Chairman of the President's Council of Economic Advisors in June of this year.
I wrote and said at the time this was probably a stepping stone to the Fed chairmanship. It was a way for Bush to get to know him personally. Bush likes to know his major appointments on a personal level, and this is one of his most important appointments of his presidency. It was unlikely to go to a stranger. Clearly, Bernanke passed the personal presidential tests. By all accounts, Ben is well liked by his peers as well. He is an economic insider, who is as suited academically for the task as anyone.
It is unlikely we will see many changes in Fed policy, at least his first year. Bernanke has written at length that the Fed should set specific inflation targets. Greenspan likes soft targets. But for all intents and purposes, the Fed has had a target of 1-2% for the core rate. Bernanke would not change that. Maybe, over a long time we get to more explicit targets, but not next year.
Secondly, Bernanke has advocated a more open Fed policy. I think we will see a more transparent Fed, and this is a good thing.
But Greenspan does not hand Bernanke an easy job. There are serious imbalances that will have to be dealt with over the coming years. There is no housing bubble, Bernanke tells us this week. Yet the markets and buyers in certain cities will be the ultimate judge. Certainly, there are signs the housing market is slowing. The number of housing sales has been gradually slowing and the number of homes for sale, especially in some overheated markets, is rising. The average price paid for a home is dropping. As mortgage rates rise, this will make housing less affordable. It also means that cash out financing is going to be more difficult.
A Slower Muddle Through Economy
We see today that GDP for the third quarter is estimated to be a very healthy 3.8%. Greenspan is leaving while things look good. But Bill Gross suggests that things might not look good for long. Writing this week:
"Typically an economic slowdown occurs 18 months after the beginning of an upward move in 5-year rates, and this cycle appears to be no exception with industrial production and service-related indicators having peaked nearly a year ago. We are due for what appears to be a 2% or less GDP growth rate in 2006, a rate sure to stop the Fed and to induce eventual ease at some point later in the year. It will likely be Bernanke's first policy shift and an indicator of his willingness to address the Fed's dual mandate of inflation targeting and economic growth."
Such a slower growth is what I have thought as well, as I think much of the rest of the decade could be a Muddle Through Economy. (I hope I am wrong.) This could cause some late nights in the Chairman's office. Martin Wolf, writing an open letter to Bernanke in the Financial Times, made the following points:
"You [Ben] will need to react strongly to low probability, high cost dangers. You have shown your willingness to do just this with your contributions, in 2002, to the analysis of the risks of deflation. As important, you will need to act as lender of last resort in times of financial panic. The Greenspan Fed was outstanding in its response to such crises, from the stock market crash of 1987 to the aftermath of the Russian default of August 1998 and the terrorist attacks of September 2001. Similar tests will lie ahead, if not more so.
"Why do I write "if not more so"? The answer is one you have identified in your writings on the "global savings glut". We share the view that the US has rightly been acting as spender and borrower of last resort in the world economy. In seeking internal balance - or the maximum level of employment consistent with stable inflation - the Fed has had to offset the contractionary impact of the net private and official capital inflows, now running at over 6 per cent of US gross domestic product. If the Fed had not taken this action, the world would have been at risk of a deep recession, if not of something even worse.
"The willingness of US monetary and fiscal authorities to sustain demand in this way has been highly desirable. But, at some point, probably on your watch, there will be a correction. Most analyses suggest that this will require a very large depreciation of the real exchange rate, to shift output towards - and domestic demand away from - tradeable goods and services. Such a depreciation would require a big fall in the dollar and rise in domestic prices of tradeables. It would also, almost certainly, entail a jump in long-term interest rates.
"Managing this adjustment, without either a deep US recession or an inflationary spiral, would test even an Alan Greenspan. The Fed will need to be both flexible and determined. It will probably have to endure unpopularity, as well. Mr. Greenspan was lucky enough and clever enough to be popular for much of the time. But good central bankers must expect to be unpopular at least some of the time. This job is as much a test of character as of intelligence.
That sums up the problem facing the Fed during the next slowdown/recession. If they fight a deep recession (and they will!! see the comments on Bernanke's speech below), which is by definition deflationary, they risk inflation. It is an extremely difficult proposition. As I have said for years, I think the best they can do is give us a slow growth Muddle Through Economy, as we correct the imbalances.
If Bernanke can pull that off, he should be treated with far more respect than Greenspan, who never faced such a problem. Greenspan was Fed chair at the right time. Not that he did not do a very good job, but now Bernanke has to deal with the aftermath. Not an easy task. But I should note, if we are in a Muddle Through, slow growth economy, no one will be very happy. Bernanke will not be celebrated, I fear.
However, given the recent strength of the economy, the Fed is going to continue to raise rates. We will see 4.25% by the end of the year. Given that the Bernanke speech which we will discuss in a moment is the famous "printing press" speech, it is going to be hard for him not to raise rates once more at the very least to establish himself as a worthy opponent of inflation, assuming the economy does not soften that much during this quarter. So, 4.5% is quite possible early in the first quarter at the January Fed meeting. Will such a move help precipitate the slowdown Gross predicts?
I think that we are probably at the top of the inflationary cycle. For reasons outlined over the past few years, I think the normal course of the world is deflationary. That is the problem that we may be discussing if the US enters into slowdown/recession. And that brings us to Bernanke's speech. It is the one where he talks of printing presses and helicopters dropping money, which is what most people focus on. That is not the reason to pay attention, however. There are some real clues as to Bernanke's mindset in this speech. Let's look at it in detail.
I believe this was his first major speech as a Fed governor. It was made to the Economist Club in Washington on November 21, 2002. The economy was in the doldrums, and there was a real concern about the possibility of actual deflation coming to US shores. Dennis Gartman referred back then to this speech as "... in our opinion the most important speech on Federal Reserve and monetary policy since the explanation emanating from the Plaza Accord a decade and a half ago."
We will look at the particulars in a few paragraphs, but we need to keep in mind this was not a random speech. While Bernanke states that the views in this speech are his own, for reasons I will go into later, I believe this speech was indicative of the thinking of various members of the Fed, and was given to make unambiguous the Fed's views on deflation. The title of the speech is very straightforward:
Deflation: Making Sure "It" Doesn't Happen Here.
First and foremost, as Gartman wrote, "Dr. Bernanke has made it clear that the Federal Reserve Governors are painfully aware of the very severe problem that a pervasive deflation would manifest upon the US economy and the US society, and they are not prepared to allow that to happen. They will do what they must in order to alleviate deflation, including erring openly upon the side of inflation..."
On one level, this speech breaks no new ground from that of the previous Federal Reserve white paper on the causes of deflation in Japan, and what the US Fed and other central banks could do to avoid deflation. I wrote about that paper in the summer of 2002, stating that it was clear to me, at least, that the Fed understood the nature of the problem and was telling us they did not intend to see the US slip into deflation. This is one reason I believe the speech is reflective of Fed thinking, and not simply Bernanke's thoughts.
A Very Clear Fed Speech
The difference between that paper and Bernanke's speech is two-fold. The paper was presented in the framework of an academic exercise, and had no official stamp of Fed governor approval. It could be viewed as theoretical, although I and a number of other analysts did not see it that way.
Secondly, this speech was actually delivered in very clear, well written English. The average layman could read and follow the thoughts. You can read the speech here
First, let's go to the more controversial parts of the speech. What are they (the Fed) willing to do to avoid deflation? This is the part that has raised the hackles of more than a few writers. I will quote:
"As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.
"The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
"What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. ......If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."
Bernanke goes on to point out that the Fed could also supply interest free loans to banks, monetize foreign assets, buy government agency bonds, private corporate assets or any number of things that could induce inflation.
Those words, taken out of context, could be seen as rather extreme, confirming the worst fears about central banks among certain groups and yet another reason to buy gold. There may be reasons in this speech to want to add a little gold to your portfolio, but these sentences are not among them.
Let's look at what Bernanke really said. First, he begins by telling us that he believes the likelihood of deflation is remote. But, since it did happen in Japan, and seems to be the cause of the current Japanese problems, we cannot dismiss the possibility outright. Therefore, we need to see what policies can be brought to bear upon the problem.
He then goes on to say that the most important thing is to prevent deflation before it happens. He says that a central bank should allow for some "cushion" and should not target zero inflation, and speculates that this is over 1%. Typically, central banks target inflation of 1-3%, although this means that in normal times inflation is more likely to rise above the acceptable target than fall below zero in poor times.
Central banks can usually influence this by raising and lowering interest rates. But what if the Feds fund rates falls to zero? Not to worry, there are still policy levers that can be pulled. Quoting Bernanke:
"So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.....
"A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
"Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years."
He then proceeds to outline what could be done if the economy falls into outright deflation and uses the examples, and others, cited above. It seems clear to me from the context that he is making an academic list of potential policies the Fed could pursue if outright deflation became a reality. He was not suggesting they be used, nor do I believe he thinks we will ever get to the place where they would be contemplated. He was simply pointing out the Fed can fight deflation if it wants to.
With the above as background, now we can begin to look at what I believe is the true import of the speech. Bernanke clearly feels that the Fed can stimulate demand in the economy. Read these sentences, noting my bold, underlined words:
"...a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero."
"The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending..."
Again: "...some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy."
"To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys."Now let us go to his conclusion: "Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy's underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. Moreover, as I have discussed today, a variety of policy responses are available should deflation appear to be taking hold. Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects. For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound."
Stimulating Aggregate Demand
Let's forget for the moment the debate about whether Fed policy can actually stimulate demand at all times and places. The quotes above demonstrate that Bernanke and the Fed board believes that is does. Beliefs will translate themselves into action. The Fed, when faced with slowing demand and deflation, will act in very predictable ways based upon their beliefs.
They will work to stimulate demand.
Bernanke viscerally believes in the ability of the Fed to stimulate demand and prevent deflation. That is the lesson you need to take away from the Bernanke speech.
In a typical business cycle, if the economy gets "overheated" and inflation starts to rise, a central bank can raise interest rates and tighten the money supply, thus slowing business growth and profits and lowering demand and therefore price inflation. If the economy gets into recession, a dose of low rates and easy money is the prescription. "Don't fight the Fed" is a rule we have been taught. It was a good rule to follow, until 2001, when there was a disconnect between the markets and fed policy.
My concern is that we are not in a typical business cycle. Just as a number of different economic factors all came together to cause the boom and then bubble of the 80's and 90's (disinflation, lower interest rates, lower taxes, lower international tariffs, the demographics of the Boomer Generation, stability, etc.), I think there are now forces at work which may not respond to the Federal Reserves levers (such as inflated housing prices, a monster trade imbalance, large government deficits, huge personal debt burdens and a boomer generation which will need to save more to retire, among many issues). But that does not mean the Fed will not pull them.
For Bernanke, "Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers."
The deflation that will be coming to us in our future will not come as a result of a drop in aggregate demand, but as a result of excess production capacity and the rising influence of China and other markets where cheap labor accompanied by the build-up of too much production capacity is driving down production costs. It is acerbated by the continued competitive currency devaluation upon the part of many of the trade partners of the US. This is a tide of deflation that is sweeping the world. It is a global phenomenon, and not isolated to just one economy.
My concern is that the United States, in isolation, cannot prevent global deflation from coming to our shores without help from the rest of the world. And to date, we are not getting any help at all.
Bernanke is going to have a difficult task as he faces a slowing US economy. When does he shift policy? I doubt he knows today. But if he raises rates too high or keeps them there too long, he risks more than a mere slowing economy. Let's hope he has the touch. Stay tuned.
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